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Prudent Investor Update, February 14, 2018

Municipal finance staff know that when it comes to tax dollars, accountability is key. Councillors expect it. The public demands it.

The prudent investor standard will open the door to more options and opportunities, and many municipalities may be approached by investment service providers seeking their business. But how can any municipality ensure that its interests will come first?

The first step is to understand where there may be potential conflicts of interest when working with investment dealers/brokers and portfolio managers. There are rules about disclosing and discussing conflicts, but sometimes the details can get lost in the fine print. It is important to understand that the financial services industry is heavily regulated, and in general, self-dealing is prohibited by law. As a municipal official, you need to be aware of your rights as a consumer of financial services.

While it may seem obvious, getting a handle on the nature of the compensation provided to the investment dealer/broker and portfolio manager is key.  A frank discussion about compensation will help to manage expectations on both sides and establish the understanding that potential conflicts arising over the course of the relationship will be brought to the municipality’s attention. Good investment advisors are happy to have the discussion, where they can articulate their value proposition and demonstrate the quality and integrity of the services being offered.

Investment Dealer Compensation
Clear conflicts of interest may come into play in the way the dealer is compensated. If, for example, an investment dealer receives a higher commission for one product over another, then that dealer may try to sell more of that product, even where a less expensive product may do just as well. On the other hand, some products take more time and skill to place with a client, because they are more complex.  So, a higher commission is warranted. In all cases, an open discussion about compensation is essential for the municipality to determine whether it is getting good value.

Indirect Conflicts
In a large institution, like the big banks that offer multiple investment services and products, there can be other and more indirect potential conflicts. There are rules, for example, that are designed to prevent large financial institutions from providing financial incentives which favour the sale of proprietary products over products which originate from a third party.  Despite this, empirical data suggest that a financial institution’s proprietary products generally make up a disproportionate percentage of that institution’s sales.  This is fine as long as the proprietary products perform as well as third-party products and are offered at fees that are comparable to third-party products.  

In another example, research analysts have been known to make a “Buy” recommendation for their own institution’s products or for stocks issued by clients of the firm, in response to internal pressure. While regulatory action has been taken in response to practices deemed to be abusive, municipal officers should be aware of this history and be prepared ask tough questions if necessary.

Portfolio Manager Compensation
Unlike an investment dealer or broker, a portfolio manager is often compensated through a management fee for “managed accounts,” that is based on a percent of the total value of the portfolio being managed. So, while transaction-based commissions are less of a concern, there are still important questions to ask about compensation. For example, the municipality should understand what the management fee covers, and the municipality should make it clear that it does not expect to pay additional fees and expenses unless they are transparent. Often there are third-party expenses, like custody fees. These can include separate fees for things like collecting income from bonds or processing transactions.  Municipalities should ask about the protocol for such expenses and make it clear that they do not expect any surprise or undisclosed fees or charges.

Broker Commissions and Errors
Other areas that can impact the returns to the municipality’s investment portfolio include: the portfolio manager’s duty to obtain best execution, use of “soft dollars” and treatment of trade errors.

Portfolio managers must direct buy/sell orders to brokers and dealers who deliver “best execution,” routing the order in a way that is most advantageous for the client in given market conditions. “Best execution” does not always mean directing the order to the broker charging the smallest commission. There are many different factors in making that determination. A municipality should ask a portfolio manager how he or she meets his or her best execution obligations.

Soft dollars involve paying the broker a commission higher than the actual cost of executing the order. The difference is said to cover value-added services, like research and analysis. But it can be unclear what true ‘value add’ was provided to the client, or what part of the cost is for additional services. In the past, there have been instances of abuse of soft dollar commissions. All portfolio managers must have written policies that set out the kinds of goods and services that can be purchased with the soft dollars, and how they are used to benefit the client accounts. Municipalities, like all clients, are entitled to ask for and receive a copy of such policies.

A trade error occurs when an unintended data entry or other administrative mistake is made.  In today’s world, most trading is largely electronic and computer-driven.  But sometimes the wrong order is placed by a portfolio manager, or for the wrong amount.  When that happens, the portfolio manager, and not the client, should bear the corrective costs.

While it is difficult to monitor all activities, asking questions and getting the advisor’s policies on these matters will demonstrate that the municipality is a diligent investor.  Being informed on these matters, including casting an open but skeptical eye on some of the marketing pitches made by financial professionals, should help to protect the municipality from making inappropriate investments or paying above market rates for services.

All of this can seem like a lot to digest and manage for a municipal finance department. Even the City of Toronto, the largest municipality in Canada, has hired an investment consultant, in addition to its investment board, to help oversee these matters. Getting impartial expertise can be valuable. Some municipal investors might join ONE Investment, which aims to provide the oversight and expertise needed for the municipal context. As a non-profit without competing financial interests, ONE can focus on the best interest of its clients, and the broader municipal sector.

Look to our next e-newsletter for more information on how to ensure compensation for investment professionals aligns with municipal goals.